Inverse Exchange-Traded Funds versus Shorting Stocks

In bear markets, one of the tools we can benefit from with our covered call writing and put-selling strategies is inverse exchange-traded funds (ETFs). An inverse ETF is also known as a short ETF or a bear ETF. These securities are constructed to return the exact opposite performance of a certain benchmark or index. Many investors consider inverse ETFs the same as short-selling stocks, where shares are borrowed and sold at the current price in expectation of buying them back at lower price thereby generating a credit. We will not focus in on leveraged inverse ETFs because I feel they are not appropriate for most retail investors using these conservative option-selling strategies. This article will explain the mechanism of inverse ETFs and highlight the pros and cons of each investment approach.

How do inverse ETFs work?

These securities use derivatives and positions in multiple securities such that the daily gain or loss is the inverse of the traditional index. If the S&P 500 is up 2% in one day, its inverse ETF would be down 2% that same day. Each trading day the inverse ETF rebalances its investments to maintain a constant leverage ratio so the relationship between it and the associated benchmark or index will line up over the short-term but usually not longer time frames.

The shares are sold at $1000.00 and bought back at $1000.00, so there no loss or gain outside of fees.

Results from using an inverse ETF

After week #1, the value of the security is up 10% to $1100.00 (as the index declines by 10%)

After week #2, the value of the inverse security is up 11.11% (resulting from the share decline from $900 to $800.00) to $1222.00

After week #3, the value of the security is down 25% (resulting from share appreciation from $800.00 to $1000.00) to $916.50

In this hypothetical, the inverse ETF results in a loss of $83.50 compared to the breakeven of short-selling. In the long-term, inverse ETFs tend to under-perform due to daily re-balancing of these securities.

Other factors to consider

Both strategies take advantage of declining markets but only inverse ETFs can be used in conjunction with our option-selling strategies. On the negative side, inverse ETFs come with expense ratios averaging 1%.

Short-selling will better match dollar-for-dollar the longer-term movement of the index or benchmark but short-sellers would be responsible for payment of stock dividends in certain circumstances and may be susceptible to margin call. Here is a chart summarizing the pros and cons of each strategy:

Inverse ETFs versus Short-Selling

Some might add that another advantage of inverse ETFs is that the maximum loss is limited to the cost of the shares whereas there is unlimited loss potential with shorting because share price can theoretically move to infinity. This assumes that there is no exit strategy opportunities executed and that simply does not apply to The Blue Collar Investor community.

I created a real-life $100k portfolio to demonstrate actual transactions in my brokerage account demonstrating how to trade in a bear-market environment using Dow 30 stocks in a long-term buy-and-hold portfolio. Charts were created for the underlyings to graphically better understand the timing of these trades.

Also, Ask Alan video # 145 will be added to the library of these videos this week. The screenshot below shows the locations of all Blue Hour webinars and Ask Alan videos:

Premium web page

Upcoming events

1- The Association for Technical Analysis (AFTA): Dallas Texas

“How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using Two Low-Risk Options Strategies”

BCI: Selling all in-the-money strikes for all new positions. Currently fully invested and rolling down to out-of-the-money strikes (as they relate to current market value) when opportunities arise. Will re-adjust when the market settles.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a bearish sentiment. In the past six months, the S&P 500 was up 2% while the VIX (21.41) moved up by 125%. Historically, the VIX and S&P 500 are inversely related.